Debt is part of the economy, like its counterpart assets and the trade in physical goods. The credit system made a major contribution to the fact that economic development has been consistently positive since industrialisation and society has been able to benefit from it. Whereas the balance of debt/credit had remained more or less in equilibrium until the 20th century, it is now worryingly debt-ridden. Increasingly higher liabilities of states, companies and households have led to over-indebtedness, which is worrying. Considering that, according to the Institute of International Finance, global debt rose to a total of USD 250.9 trillion or 320% of global GDP in the first half of 2019, the concern is also understandable.

 

Role of financial institutions

In the credit sector, banks used to play both the role of creditors and that of a hinge between other creditors and debtors. The business model was relatively simple, with maturity and creditworthiness determining the interest rates to be set on both sides and the difference being the mainstay of the return. When performing an intermediary function, creditworthiness and reputation were paramount.

Today’s credit system is still theoretically based on the same principles but has changed a lot over time. There are many more credit providers, an increasing number of which are not banks at all. Increased competition has led to lower margins, which have become almost “quantité négligeable” in the current interest rate environment. The restriction of money creation opportunities through higher equity ratios has only exacerbated the situation. It almost goes without saying that the banks have sought and found alternative and innovative ways of lending.

 

Foreign words and acronyms in the financial world

It has become fashionable to use English designations in the German language and the financial sector is also affected by this. Especially new, innovative products in the credit sector are often provided with English words. “Barrier reverse convertible”, for example, is a short-term security issued by a bank with a higher coupon, whose repayment depends on the performance of a certain number of shares. Should the English term only be a marketing aid or should it distract from the risks associated with a share/bond? Worse, however, is the use of acronyms (use of the first letters), the meaning of which is difficult even when deciphering the letters. The letters CDO (collateralized debt obligation) as a term for the securitization of mortgages are unforgotten, as this product led to the financial and economic crisis of 2008. Perhaps the term MBS (mortgage backed securities) would not have caused the same fate, but it would have been more understandable.

 

Leveraged loans and CLOs

Leveraged loans are loans granted to companies that are highly indebted and/or have a poor credit rating. These are securitized by a bank syndicate into Collateralized Loan Obligations (CLOs) and sold to investors. According to S&P Global, there is currently around USD 1,400 billion in such loans outstanding, more than double the amount since the financial crisis of 2007/2008, roughly the same as the volume of the high-yield bond market.

The Bank of England estimates the total size of the global leveraged loan market at USD 2.2 trillion, or 9% of all outstanding loans to companies in the developed world. It estimates the size of the CLO segment at USD 750 billion. The difference to S&P Global’s figures is due to the lack of a precise definition of what constitutes a leveraged loan. Regardless of the exact figure, it is clear that the volume is very large and that investor protection (unclear creditor relationships) has declined.

 

Playing with fire

There is a danger that the over-indebtedness of states, companies and households could escalate into wildfire, as is currently the case in Australia. How such a fire can be fought or put out is written in the stars. What is certain is that the plant emergency does not justify a fire accelerator in the form of securitised loans. Unfortunately, the financial industry has repeatedly managed to provoke stock market crashes (1987 portfolio insurance, 2008 CDO) that need not have happened.

 

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Christian Wagner
Financial Advisor